Growth unexpectedly eased in the first half of 2015. Poor productivity, in part the flip side of increasing employment, seems to have weighed on exports. Yet the fundamental drivers of growth are generally supportive.
After a barnstorming performance in 2014, UK growth unexpectedly eased in the first half of 2015. GDP rose a lackluster 0.3 percent between the fourth quarter of 2014 and the first quarter of 2015, a weaker performance than that of the euro area economy. A slowdown in service sector output was a principal culprit, but the United Kingdom’s trade performance remains strikingly weak. The United Kingdom’s poor productivity performance, in part the flip side of its success in increasing employment, seems to have weighed on export performance, as has the strengthening of the British pound against the euro. Yet the fundamental drivers of UK growth are generally supportive, and domestic demand remains perky.
Monetary and financial conditions are easy, with strong growth in consumer credit and signs of a revival in corporate credit demand. The risk appetite in financial markets has been fairly buoyant this year, with risk assets such as equities outperforming bonds. The labor market has tightened significantly in the last year. Employment has hit an all-time high, despite the public sector having shed 1 million jobs in the last six years, and the unemployment rate has dropped to an eight-year low of 5.5 percent.1 Indeed, the United Kingdom has a higher proportion of its working-age population employed than the United States, an economy that Britain has long looked to as a model of labor market flexibility.
A tightening labor market is starting to generate upward pressure on wages after several years of little, if any, growth. Growth in average earnings has accelerated markedly in the last year. And with inflation around zero, and likely to stay thereabouts for the rest of the year, the stage seems set for a long-awaited recovery in consumer spending power.
One major uncertainty for the UK economy was resolved in the second quarter of the year. The May 8 general election avoided the widely expected outcome of political gridlock and, instead, delivered a majority Conservative government. This has avoided any precipitous change in or chronic uncertainty around economic policy. But it has, simultaneously, created a significant new uncertainty, with the possibility that UK voters could vote to leave the European Union in a referendum on membership due to take place within the next two years. This seems an outside chance rather than the most likely outcome: The referendum campaign is likely to see all political parties, with the exception of the UK Independence Party, campaign for continued membership (albeit with a significant minority of Conservative Party MPs campaigning for withdrawal). Moreover, most business lobby groups seem set to support continued membership.
Public opinion has already shifted in a more pro-EU direction. A Pew Research Center survey carried out in the second quarter of 2015 showed support for remaining in the European Union at 55 percent, with 36 percent of voters favoring leaving the European Union.2 Predicting the outcome of polls two years ahead is a highly speculative business, but from where we are at the moment, the most likely outcome seems to be that the United Kingdom will stay in the European Union.
We conclude by returning to the question of UK productivity, widely regarded as the Achilles’ heel of the British economy. Many economies have faced a slowdown in productivity growth since the financial crisis, but among the industrialized economies, the United Kingdom’s performance has been conspicuously poor.
One comforting theory is that output has been underestimated in recent years, and, as a result, productivity growth has been underestimated. Certainly GDP numbers are choppy and prone to revision, often years after the event. If GDP gets revised up—and it often does—the United Kingdom’s productivity performance will look better. Another angle on this theme is that technology is raising welfare in ways that are not being recognized in conventional measures of economic activity—for instance, people getting free music and videos via video-streaming sites or using free online map services.
But, for us, a leading suspect in this story is that the financial crisis made credit hard to come by, companies became averse to risk, and investment and innovation collapsed. The resulting deterioration in the United Kingdom’s stock of tangible and intangible assets—from machinery and buildings to highly trained workers, and research and development—has made employees less productive.
If this is the case, then a revival in capital spending will, in time, reboot productivity. Collectively, UK companies have ample reserves of cash. The largest businesses, which are the main drivers of capital spending, have good access to credit. The corporate sector probably has the means to invest, and, with existing capital assets wearing out, they have a growing need to do so.
The next few years are likely to see stronger capital spending, which will give a fillip to productivity. At the same time, rising demand will mean more work for existing employees—who during the downturn might have been involved in internal projects, marketing, and bidding—and this will reinforce the recovery in productivity.
More time and investment should help revive UK productivity growth. If not, the United Kingdom is moving into an era of slower growth as well as slower growth in living standards.